NOTE NUMBER 344 102736 viewpoint PUBLIC POLICY FOR THE PRIVATE SECTOR O ctober 2 0 1 4 Contract Farming Nicholas Minot and Risks and Benefits of Partnership between Farmers and Firms T r a d e a n d C o m p e t i t i v e n e s s G l o b a l P r a ct i c e Loraine Ronchi Contract f arming inv o lv e s p r o d uc t io n b y f a r m e r s und e r a g r ee m e n t Nicholas Minot is a Senior Research Fellow in with b uyers f or t he ir o ut p ut s . T his a r r a ng e m e nt c a n he lp in t e g r a t e the Markets, Trade, and small- scale f arme r s int o m o d e r n a g r ic ult ur a l v a lue c ha ins , pr o v i d i n g Institutions Division of the m with inp uts , t e c hnic a l a s s is t a nc e , a nd a s s ur e d m a r k e t s. C r i t i c s the International Food Policy Research Institute. conte nd that co nt r a c t p a r t ne r s m a y s ub je c t f a r m e r s t o a b use s . T h e Loraine Ronchi is the literature shows t ha t in f a c t c o nt r a c t f a r m ing c a n r a is e f a r m i n c o m e , Global Agribusiness Lead for the World Bank b ut mainly f or hig h- v a lue c r o p s . I t a ls o ind ic a t e s t ha t in m a n y Group’s Trade and cases f irms are willing t o wo r k wit h s m a ll f a r m s . T his no t e c o n f i r m s Competitiveness Global Practice. that conf licts are c o m m o n b e t we e n b uy e r s a nd f a r m e r s , a nd t h a t alternative d isput e r e s o lut io n m e t ho d s m a y he lp r e s o lv e t hem . Government intervention in agricultural foods to commercial production of higher-value marketing has declined in recent decades as crops, allowing them access to the wider economy private firms have become more involved in and raising their income (Eaton and Shepherd the trading, storage, processing, and export 2001). of agricultural products. Market reforms have Countering the favorable view of contract allowed for the expansion of contract farming, in farming, there are concerns that firms may which agro-enterprises contract farmers before exclude small-scale farmers, preferring to work planting to supply specific agricultural products, with a smaller number of larger farmers, thus THE WORLD BANK GROUP sometimes providing technical assistance, inputs exacerbating rural income inequality. Other on credit, and an assured market (Gulati et al., analysts argue that where companies work 2006). with smallholders, the imbalance of power and Some analysts see contract farming as a information between them enables agribusiness solution to a number of constraints that limit the firms to impose contract terms on small farmers, productivity and income of small-scale farmers manipulate quality standards to reduce payments in developing countries, including lack of credit, to farmers, and renege on agreements if market limited information about production methods, conditions change (Glover 1984; Little 1994). market risk, and poor market linkages. In this This note draws upon a growing body of view, contract farming can help farmers move empirical research on contract farming in from subsistence production of low-value staple developing countries in examining how contract o n t r a c t F arming C ontract arming Risks and Benefits of Partnership between Farmers and Firms farming affects the well-being of participating controlled conditions to avoid contamination farmers and whether the practice tends to with seed from other varieties or crops. In these exclude small-scale farms. Resolving frequent situations it is easier to communicate and enforce conflicts between farmers and firms through quality requirements if the buyer contracts the legal system is costly and time-consuming. farmers to grow the product. In contrast, there This note, therefore, explores the experience of is less incentive for buyers to contract farmers alternative dispute resolution (ADR) mechanisms when the product will be sold as a staple food in resolving issues out of court. for price-sensitive consumers. The prevalence of contract farming differs 2 Companies, crops, and conditions best suited substantially across commodities. Contract for contract farming success farming is relatively common in the case of Reliable figures are not yet available on the fruit and vegetable production for export number of farmers in developing countries or sale to domestic supermarket chains, as is participating in contract farming. Informal the case in Kenya, Madagascar, and Senegal. estimates suggest that as many as one-quarter of Many traditional agricultural export crops Kenyan farmers may be on contract. But rates in such as tea, oil palm, and rubber are often most countries are probably much lower. Farm grown on “nucleus estates,” company-owned surveys in Ghana, Uganda, and Vietnam suggest plantations surrounded by independent growers that less than 5 percent of farmers participate in who produce under contract. The Kenya Tea contract farming. A seven-country study by the Development Agency, a private firm, has one World Bank Group found that only 7 percent of of the largest contract farming networks in sampled households were involved in any type the world, with more than 500,000 small-scale of agricultural production contract, including growers. Commercial poultry production is informal agreements with traders (Losch et al. often carried out under contracts in which a 2011, 157). firm provides chicks, feed, and other inputs The prevalence of contract farming varies to the farmers and commits to buying the widely by type of buyer, destination market, chickens when grown. Cases of contract and commodity. Contracting firms are almost poultry production have been documented in always relatively large processors, exporters, or Bangladesh, India, Indonesia, and Thailand. supermarket chains. Rarely do small-scale traders Milk production is often organized contractually or even wholesalers offer farmers pre-planting by a dairy processor to coordinate the supply contracts. This is not surprising given the large of this highly-perishable product. Reforms in fixed costs associated with contracting. Firms India have transformed the milk sector, as the must establish a network of trained field agents role of private processors, some of whom offer who recruit farmers, provide advice, monitor contracts, has grown dramatically relative to compliance, and organize collection of the harvest. the dominant dairy cooperatives (Birthal et al. Large firms have a bigger incentive to ensure a 2008). steady supply of raw materials, readier ability to Contract farming is rarely used in the production extend credit, and greater capacity to absorb the of staple cereals, roots, and bean crops. This is risk associated with offering a fixed price. presumably because buyers are less quality sensitive, Contract farming arrangements are often and markets are widespread, so spot markets are created for markets willing to pay a premium able to coordinate supply and demand without for specific product attributes. Export markets the additional costs associated with contract and supermarket chains establish quality production. Exceptions include barley for large- standards and demand products of a certain scale breweries, grain seed production, and niche size, color, maturity, and flavor. In serving these products such as organic rice. markets, processors often need products to meet requirements in terms of uniformity and Increased income for contract farmers chemical characteristics. Seed companies require Early studies of contract farming observed that that their growers multiply seed under carefully farmers appeared to earn higher incomes than their neighbors who were not on contract (Glover econometric studies measuring the impact of 1984; Minot 1986; Little 1994), but these studies contract farming on income and revenue. The did not establish causality. Later studies used estimated change in income for contract farming econometric analysis to control for education, over the average income for non-contract farm size, and other observable characteristics farming in all these studies ranges from negative that might contribute to income differences 49 percent to an increase of 600 percent. Most between contract farmers and others. Some found an increase of between 25 and 75 percent. factors, such as skills and industriousness, are not This sizable income increase is not surprising easy to measure. The most rigorous studies have given that contract farming ventures which do 3 used instrumental variable analysis, resulting not provide farmers higher incomes (or some in estimates of the impact of contract farming other benefit, such as more stable income) are alone. Table 1 summarizes the results of rigorous likely to lose farmers and eventually fail. Table Studies examining the impact of contract farming on income or revenue 1 Study Location Commodity Results Warning and Key, 2002 Senegal Groundnuts Heckman selection model used to estimate increased income. Increases in gross agricultural revenues are 55% greater than average non-contacting farmer. Participation in contract farming associated with 39% increase in gross agricultural income over non-contract farmers. Simmons, Winter, and Indonesia Poultry; Maize; Rice Contracting improves returns to capital for poultry and maize seed, but not for rice seed. Patrick, 2005 Contract farmers had 71% and 160% increase in gross margin for seed corn and poultry, respectively, over sample average. Ramaswami, Birthal, and India Poultry Based on IV regression analysis, contract poultry growers earn 36% more per kilogram per Joshi, 2006 production cycle than independent growers. They also had lower variability in gross margins between production cycles. Birthal Jha, Tionco, and India Dairy, Poultry, Treatment effects model finds that participation in contract production increases net revenue Narrod,2008 Vegetables more than 80% compared to the average. Bolwig, Gibbon, and Uganda Coffee Positive revenue effect for contract farmers compared to a control group on non-contracting Jones, 2009 farmers. With full information maximum likelihood (FIML) estimation, the average effect is a revenue increase of 75% in net coffee revenue relative to no contract participation. Miyata, Minot, and China Apples and Treatment effects model finds a 38% increase in income associated with contract farming. For Hu, 2009 Green Onions apples, additional income is attributed to higher yields; in the case of green onions, prices received by contract farmers were higher than those received by non-contract growers. Saigenji and Zeller, 2009 Vietnam Tea Propensity score matching approach used to control for effect of observable characteristics. Study finds that participation in contract tea production raises household income by 40% above that of similar non-contract farmers. Jones and Gibbon, 2011 Uganda Cocoa Contract participation increased real net cocoa revenue by 58% to 168%, depending on the econometric model used. Bellemare, 2012 Madagascar Vegetables, Fruit, A 1% increase in the likelihood of participating in contract farming is associated with a and Grain 0.5 percent increase in household income. This implies that the average effect has an upper limit of 50% of income. The study also found that participation also increases income from non- contract crops and from livestock production. Ferguin, Anseeus, and South Africa Fruit, Vegetables, Contract farmers benefit from a seven-fold increase in income, significant at 5% level, and D’Haese, 2012 and Poultry better access to services and resources, and opportunities to participate in new markets. Participation remains limited, however, mostly involving the better-off farmers. Cahyadi and Waibel, 2013 Indonesia Palm Oil Estimated contract participation increased net household income by 60% (significant at the 10% level). Results show that while contract farming has a significant positive effect on smallholder income overall, poorer smallholders are less likely to benefit. Narayanan, 2014 India Gherkins, Papaya Participation in contract farming increased profits of gherkin farmers by 21%, papaya farmers Marigold, and Poultry by 32%, poultry farmers by 150%. Contract farmers in marigold earned 49% lower profits than they would have outside the contract farming venture. C ontract F arming R i s k s a n d B e n e f i t s o f P a r t n e r s h i p b e t w e e n F a r m e r s a n d F i r m s Who’s on contract? Small farms in the mix contractors may shift strategies over time as they Do companies that contract farmers prefer gain experience or as market conditions change. medium- and large-scale farmers? A review of the Tomato contractors in Mexico shifted from large- evidence suggests that in many cases companies to small-scale farmers, while vegetable exporters are willing to work with small farmers, but that in Senegal and pineapple exporters in Kenya some crops have economies of scale that favor gave up contract farming in favor of plantation medium- and large-scale farmers. Most studies production (Runsten and Key 1999; Maertens detect no significant difference in farm size and Swinnen 2007; Minot and Ngigi 2004). In between contract farmers and other farms in a summary, the evidence suggests some contractors 4 given region, a finding that points to a role for prefer to work with large-scale farmers, but many contract farming in inclusive growth and poverty production plans involve small-scale farmers. reduction. Although working with fewer large-scale farmers As shown in Table 2, several studies have found reduces transaction costs, this is often outweighed that farm size was not a significant determinant by the higher overall costs and lower productivity of participation in contract farming, and several of wage workers as compared to small-scale family more found that contractors actually preferred farms. smaller farmers (Miyata et al. 2009; Key and Runsten 1999; Warning and Key 2002; Birthal Resolving contract farming disputes et al. 2005; Shankar et al. 2010). Other studies Conflicts between contractors and farmers are have found that contract farmers were larger than frequently about quality standards and price. If average (Guo et al. 2002; Wang et al. 2010). The market prices rise, contracted farmers may be contrasting results may be partly explained by tempted to sell on the market rather than to commodity. For example, in Indonesia contract the buyer. Contractors may be tempted to falsify seed growers tended to be larger than average, quality testing as a way of reducing the price they while contract poultry farmers were smaller pay to farmers under contract, particularly when than average (Simmons et al. 2005). Another market prices have fallen. In many countries, study found that contract poultry growers were settling disputes through the legal system is younger and less experienced than non-contract impractical because of costs and delays. Alternative growers, implying that contracting made it easier dispute resolution mechanisms are one way to to enter and learn the business (Ramaswami et address these conflicts. ADR refers to any process al. 2006). The case study literature indicates that for resolving conflicts outside standard legal Table Determinants of participation in contract farming 2 Study Location Commodities Results Warning and Key, 2002 Senegal Groundnuts Asset ownership is not a significant predictor of contract participation. Miyata, Minot, and China Apples and Green Onions A probit model for the participation in contract farming shows no preference for larger farmers. Hu, 2009 Cahyadi and Waibel, 2013 Indonesia Palm Oil Migrant status, household head age, plot size, and time since farm establishment are all significant predictors of participation in contract farming. Saenz and Ruben, 2004 Costa Rica Chayote Younger, less experienced growers were more likely to grow under contract. Simmons et al., 2005 Indonesia Poultry; Maize; Rice Irrigation, age of head of household, and education were all found to be positive indicators of participation in contract farming across three sites in the country. Guo et al., 2005 China Fruits, Vegetables, Tea, Specialization and commercialization along with distance from market and government support Livestock are shown to be significant predictors of the likelihood that farmers engage in contract farming. Birthal et al., 2008 India Dairy, Poultry, Vegetables Experience and non-farm income are found to be significant indicators of contract farming for the dairy, vegetable, and poultry industries. Wang et al., 2011 China Vegetables Risk attitudes are found to be a significant determinant of contract farming, with more risk- tolerant farmers preferring contracts. procedures, including mediation and arbitration. negatively affected if such opportunities existed This could involve a parallel legal structure which (Torero and Viceisza 2013). offers streamlined ADR such as that established by the Agricultural Produce Marketing Act in Conclusion India in 2003. The Act has allowed 14 states to Contract farming can link farmers to a processor, set up resolution authorities required to render exporter, or supermarket chain. It can offer judgment within 30 days (Pultrone 2012). In technical assistance, deliver inputs on credit, many other cases globally, relations between the and reduce market risk, solving a number of firm and contract farmer are facilitated by an constraints that limit small-farm productivity 5 intermediary, such as a village leader, extension and income. Studies of contract farming in agent, or non-governmental organization. Third- developing countries suggest that it almost party verification of product quality can also be always results in higher income compared to used to prevent, but also to help resolve disputes that of similar farmers not on contract. In most as part of an ADR mechanism. of the econometric studies of contract farming, Rigorous impact evaluations of ADR on the incomes of participating farmers are raised 25 to success or sustainability of contract farming are 75 percent over those of similar farmers outside rare and focus primarily on the role of third-party contract farming arrangements. verification (see Table 3). One study provided A few studies have found contracting vouchers to randomly-selected dairy farmers in companies that prefer to work with larger Vietnam, allowing them to verify quality with a farmers, but most find no difference in farm third-party laboratory. These lab tests showed that size between contract farmers and other farms the company was not falsifying quality, and the in the region. This suggests a role for contract reassurance of the third-party testing incentivized farming in inclusive growth and poverty voucher recipients to increase output, resulting in reduction. Of course, farmer participation in increased dairy revenue by 16 percent (Saenger contract farming is often based on criteria other et al. 2013). than farm size, including experience, location A second study looked at contract farming of near the processing plant, and attitudes to risk. Fair Trade cotton in Mali and found that third- Ownership of equipment, such as pumps to allow party enforcement of contract terms improved year-round production, is also a factor. There cotton quality (Balineau 2013). A third study used are few if any cases of successful contract farming field experiments to show that farmers do not of cereals and other basic staples. Thus contract fully trust their contractors, but the presence of farming should be considered an institution that a third party at the quality testing increased trust has a positive effect on farmers, but not one in the validity of the results. The level of trust of that is readily applicable in some important male farmers was not affected by opportunities sub-sectors. for collusion between the company and the third- The two most common problems faced by party testers, while the trust of female farmers was contract farming ventures are side-selling by Table The impact of third-party verification on contract farming 3 Study Location Commodity Results Balineau, 2013 Mali Cotton Contract farming enforced by third-parties fosters the adoption of innovative agricultural practices. Results indicate a 2.4% to 7.7% increase in higher quality cotton being produced by contracted farmers. Saenger et al., 2013 Vietnam Dairy Experimental design shows that contract farmers invest significantly more inputs into production and produced higher levels of output in the presence of independent quality verification. Torero and Viceisza, 2013 Vietnam Dairy Male and female dairy farmers are found to differ in trusting the presence of a third party observer on product quality in the face of potential collusion. Male contract farmers are more likely to trust the third party than female contract farmers. C ontract F arming R i s k s a n d B e n e f i t s o f P a r t n e r s h i p b e t w e e n F a r m e r s a n d F i r m s farmers and manipulation of quality testing by Dairying in India.” Discussion Paper 00814. contractors. Preliminary results suggest that third- International Food Policy Research Institute. party testing and other ADR mechanisms may Washington, D.C. address the latter issue, giving farmers greater Bolwig, S., P. Gibbon, and S. Jones. 2009. “The confidence in the reliability of testing provided Economics of Smallholder Organic Contract by the buyer. 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